New Foreclosures Plummet, but Fall Is Temporary

The housing market is improving, no question. Home prices are rising, albeit in fits and starts. Fewer borrowers are falling behind on their mortgage payments. All of this is true, but in no way accounts for a nearly 22 percent drop in the number of new foreclosure proceedings by banks in October.

Lender Processing Services, which reported that number Wednesday is quick to caution that the one month drop, after a spike in September, is likely due to changes in mortgage servicing that went into effect in September under the $25 billion mortgage settlement. Servicers are now required to give borrowers a 14-day notice in writing before referring a loan for foreclosures. Those letters began going out in September.

As such, the impact on foreclosure starts, while significant now, is likely to be temporary as the industry adapts to the new requirements, according to LPS's Herb Blecher. In other words, the settlement designed to protect borrowers from faulty foreclosure proceedings, is doing so but slowing the process of clearing distress yet again. This is not to be taken lightly, because until the distress is gone, the housing market will not recover at the pace we might like.

Nearly one third (1.3 million) of sales in the past twelve months have been distressed, either REO (bank-owned homes) or short sales, according to LPS. That compares to just 226,000 in 2005 when overall home sales were twice the pace they are today.

It doesn't stop there. The California Homeowners Bill of Rights goes into effect January 1, 2013. Similar legislation in Nevada doubled the foreclosure pipeline over the past year.

Another reason for the drop in new foreclosures may be a surge in loan modifications involving principal reduction. These are also mandated by the mortgage servicing settlement. Principal reduction modifications jumped 62 percent from October to November, according to Amherst Securities' Laurie Goodman.

That may in fact be due to fears of the "Fiscal Cliff" and the expiration at the end of this year of key tax relief for debt forgiveness.

If the Mortgage Forgiveness Debt Relief Act of 2007 is not extended and gets mired in fiscal cliff negotiations, borrowers will have to pay taxes come January 1 on principal reduction loan modifications as well as short sales (when a bank allows a home to be sold for less than the value of the mortgage).

There are still 5.3 million loans either delinquent or in the foreclosure process, according to LPS. While increasing optimism in today's housing market is not unfounded, one cannot discount the lingering distress and potential shadow inventory of bank-owned homes that will continue to haunt housing for the next several years.